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1
Basel III: An Overview
Seminar for Senior Bank Supervisors from
Emerging Economies
Washington, DC
18 October 2011
Elizabeth Roberts
Director, FSI
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The Basel Capital Accord (Basel I)
This multi-year project was finalised in 1988 with the
issuance of the paper International Convergence of
Capital Measurement and Capital Standards (Basel I)
A common definition of capital and risk-weight categories
was agreed
It represented the first time that a capital standard would
be applied across numerous countries
Intended for the G10 countries but ultimately adopted by
virtually all major jurisdictions
It was also the first time that the Committee had issued a
standard that had a “bite”
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From Basel I to Basel II
In the late 1990s, the Basel Committee, in recognition of
weaknesses in Basel I, began to develop a more risk-
sensitive approach to capital adequacy calculations
This included specific recognition of the need to hold
capital against operational risk (market risk had been
added to Basel I in 1996)
It also included two new pillars:
• the supervisory review process (Pillar 2)
• market discipline (Pillar 3)
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Basel II structure
StandardisedApproach
InternalRatings-based
Approach
Credit risk
BasicIndicatorApproach
StandardisedApproach
AdvancedMeasurementApproaches
Operationalrisk
StandardisedApproach
ModelsApproach
Marketrisks
Risk weightedassets
CoreCapital
SupplementaryCapital
Definition ofcapital
Minimum capitalrequirements
Supervisory reviewprocess
Marketdiscipline
ThreeBasic Pillars
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Pre-crisis problems
Too little capital and much of it of questionable quality
Excess market liquidity and the search for yield
Weak governance and risk management
Perverse incentives (salaries and bonuses)
Poor underwriting and excessive risk taking
System-wide risk and interconnections
Deficiencies in regulation and supervision
Perimeter of regulation insufficient
Procyclicality of the banking system
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Business models
Originate-to-hold Originate-to-distribute
Raise retail deposits and grant loans
which are held on B/S till they mature
High customer focus
Originate/outsource loans and distribute
through securitisation. Not retained on B/S
- Incentives for credit risk assessment?
Assets – loans
Revenue – interest income
Liabilities – retail deposits
Assets - securities
Revenue - fee income
Liabilities - wholesale funding
Credit origination, servicing and
monitoring performed by the same
bank
Main functions split into several distinct
activities performed by several separate
entities
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The age-old problem
The recent financial crisis reminded us that:
• the upside of bank risks belongs to shareholders and
bank management
• but a significant portion of the downside risk is borne
by society in general, most especially taxpayers
• “capitalize profits and nationalize losses”
• this is especially true for “too big to fail” institutions
The size of a bank‟s capital and liquidity cushions
determines how much of the risk belongs to the bank and
how much belongs to all of us
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Strengthening Basel II
Not only more capital but higher quality capital
Better risk coverage
• Failure to capture key risks amplified stress
• Enhanced treatments for:
• Trading book
• Off-balance sheet exposures
• Securitisations and external ratings
• Counterparty credit risk
Address any excess cyclicality and promote
countercyclical buffers
Non risk-based measure to contain leverage
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Strengthening Basel II
In 2009 the Committee issued two important documents,
among others, in response to the financial crisis:
• Enhancements to the Basel II framework, July 2009
(includes supplemental Pillar 2 guidance)
• Strengthening the resilience of the banking sector -
consultative document issued in December 2009
In December 2010 the Committee issued Basel III: A
global regulatory framework for more resilient banks and
banking systems (reissued in 2011 with minor
amendments related to CCR)
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Basel III – what is it?
Basel III is a comprehensive set of measures to strengthen
the regulation, supervision and risk management of the
banking sector
These measures aim to:
• improve the banking sector's ability to absorb shocks
arising from financial and economic stress, whatever
the source
• improve risk management and governance
• strengthen banks' transparency and disclosures
The reforms target:
• bank-level, or microprudential, supervision
• system-wide, or macroprudential, risks
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What about Basel II?
Basel II is NOT dead – nor is Basel I
• they continue to be viable capital standards
Basel III does NOT replace Basel I or Basel II – rather it
supplements these two standards
Basel III is about more than just capital ratios
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Basel Committee’s reform package – broad
objectives
Strengthen micro- and macroprudential frameworks
Increase financial system‟s „shock absorbers‟
Reduce channels of procyclicality
Address externalities of systemically important firms
Review perimeter and scope of regulation
Strengthen governance, risk management, transparency
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Regulatory Response to the Financial Crisis – Basel III
Raising the Level/Quality
of Capital
Supplementing Risk-
based Capital with
Leverage Ratio
Introducing a Global
Liquidity Standard
Reducing
Procyclicality
Addressing
Systemic Risk
BASEL III
M
I
C
R
O
M
A
C
R
O
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Committee’s reform package – key elements
Stronger capital framework
• increase significantly the quality of bank capital
• increase the coverage of bank capital
• increase the required level of bank capital
Larger capital „buffers‟ / reduced procyclicality
Leverage ratio as a “back-stop”
Robust global liquidity standards
Greater emphasis on macroprudential supervision
Enhanced governance and risk management guidance
Better cross-border bank resolution frameworks
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Reminder: the components of a capital ratio
Capital
Credit risk + Market risk + Operational risk
>8%
3 key components:
Each of these 3 components has been adjusted in Basel III
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The components of a capital ratio
Capital
Credit risk + Market risk + Operational risk
>8%
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At least six sub-tiers in many jurisdictions:
• Common equity Tier 1
• Non-innovative tier 1
• Innovative Tier 1
• Upper Tier 2
• Lower Tier 2
• Tier 3
Complicated system of maximums and minimums for each element or group of elements
Definition of capital – at present
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Erosion of the quality of capital
Over the past decade or so, the quality of bank capital has
eroded
Tier 1, which was intended to be the purest forms of
capital, was particularly weakened
The financial crisis highlighted the fact that many Tier 2
capital instruments were actually debt
Going concern vs gone concern issues
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Problems with existing definition of capital
Common equity can be just 2% of RWAs
Deductions not applied to common equity
• tangible common equity can be zero or even negative
No harmonised list of deductions
Weak transparency
Global banking system entered the crisis with an
insufficient level and quality of capital:
• Banks had to raise capital and de-leverage
• Result was a need for massive government support
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Objective:
• Raise quality, consistency and transparency of Tier 1
• Tighten definition of common equity (focus on
common shares and retained earnings)
• Limit what qualifies as Tier 1 capital (regulatory
adjustments such as deductions)
Main driver of new definition: loss absorption capacity
Inclusion based on clear principles
Harmonised internationally and simplified
New disclosure requirements on Tier 1 composition
(Pillar 3)
The new definition of capital
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Just three elements (much stricter definition)
• Common equity Tier 1 (predominant form of Tier 1)
• Tier 1 additional going concern capital
• Tier 2 (gone concern) capital
No sub-categories of Tier 2
Elimination of the Tier 3 category (no real impact)
Minimum requirements established for common equity
Tier 1 (CET1), Tier 1 and total capital
The new definition of capital
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The components of a capital ratio
Capital
Credit risk + Market risk + Operational risk
>8%
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Denominator – better risk coverage
The financial crisis highlighted the fact that capital
requirements for certain transactions were much too low
• trading book exposures
• complex securitisation exposures, off-balance sheet
exposures (eg SIVs)
• counterparty credit risk
The Committee increased the capital requirements for
many transactions in its July 2009 document
New rules for counterparty credit risk are being finalised
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The components of a capital ratio
Capital
Credit risk + Market risk + Operational risk
>8%
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Increase the required level of bank capital
The capital adequacy ratio is being raised
• Minimum common equity requirement will be 4.5%
(as compared to the current 2%)
• A capital conservation buffer of 2.5% will be added
to the 4.5% to make a total requirement of 7%
common equity to total risk-weighted assets
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Capital conservation buffer
Lesson from the crisis: banks were distributing earnings
even during stress periods
Demonstrated the importance of building capital buffers
during good times in order to create a cushion
These buffers should be capable of being drawn down
Buffer range above the minimum capital requirement
established (2.5%)
If bank‟s capital levels fall within this buffer range,
constraints on the distribution of dividends, on bonuses
and share buybacks (but not on the way the bank
conducts its business)
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Countercyclical buffer
The Committee has endorsed the creation of a counter-
cyclical buffer that will increase the capital conservation
buffer by up to an additional 2.5 percentage points during
periods of excess credit growth
Make the banking sector a shock absorber rather than a
shock amplifier
This buffer will be imposed when a credit bubble has
given rise to the build-up of system-wide risk
The buffer would be released when, in the judgement of
supervisors, it would help absorb losses in the banking
system that pose a risk to financial stability
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Proposed capital conservation
buffer will establish a fixed range
above the Tier 1 minimum capital
requirement. When a bank‟s Tier 1
ratio falls into this range it becomes
subject to restrictions on
distributions
Proposed countercyclical capital
buffer works by extending size of
capital conservation buffer during
periods of excess credit growth
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The functioning of the capital buffers
Minimum
requirements
Conservation
buffer
Countercyclical
buffer
Restric
tions o
n
dis
tribu
tion
s
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Raise the level of regulatory capital
Calibration of the Capital Framework
Capital requirements and buffers (all numbers in percent)
Common Equity
(after deductions)
Tier 1
capital
Total
capital
Minimum 4.5 6.0 8.0
Conservation buffer 2.5 " "
Minimum plus buffer 7.0 8.5 10.5
Countercyclical
buffer range
0 – 2.5 " "
…but remember: 8.0% under Basel I/II is not 8% under Basel III
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Raise the level of regulatory capital
2010 BoE, Financial Stability Report (a) Common equity or other fully loss-absorbing capital; (b) There is no explicit requirement, it was generally
understood that CET1 should form the predominant part of Tier 1; (c) Definition of Capital will be strengthened through new deductions from CET1
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Leverage ratio
Another lesson of the crisis: there are circumstances in
which risk-weighted capital ratios provide a misleading
picture of banks‟ overall health (the risk-weighting rules
understate the actual risks, models are flawed, etc)
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Leverage ratio: objectives
Objectives:
• Supplement the risk-based framework with a simple
measure based on total assets plus off-balance sheet
exposures (no risk-weighting involved)
• Introduce additional safeguards against model risk and
risk measurement error
• Contain build-up of leverage in the banking system
during boom periods
• Serve as an additional safeguard against attempts to
“game” the risk-based requirements
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Leverage ratio: implementation
The leverage ratio will be calculated as an average over
the quarter
Agreement to have a long transition and an observation
phase:
• Supervisory monitoring from 1 January 2011
• Parallel run period from 1 January 2013 to 1 January
2017
• Public disclosure at bank level from 1 January 2015
• Migration to Pillar 1 in 2018 (after appropriate review
and calibration)
Calibration: minimum Tier 1 leverage ratio of 3% during
the parallel run period
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The new global liquidity standard
Currently no international liquidity standard
Two global liquidity standards to be introduced
• Liquidity Coverage Ratio (LCR) – short-term
• Net Stable Funding Ratio (NSFR) - longer-term
structural ratio
Supplement the 2008 “Principles for sound liquidity
risk management and supervision”
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The new global liquidity standard
Aim of the framework is to require banks to be able to
withstand more severe shocks than they have been
able to in the past
The objective is to change behaviour: more effective
to increase the term of funding than to hoard liquid
assets
The Basel Committee will use an observation period
to ensure that the framework is calibrated to achieve
its intended objectives
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Liquidity coverage ratio (LCR)
Promote short-term resilience by requiring sufficient high-
quality liquid assets to survive acute stress lasting for one
month
Stock of high quality liquid assets in relation to net cash
outflows over 30-day stress period should be at least
100%
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Net stable funding ratio (NSFR)
Lessons from the crisis: over-reliance on short-term
wholesale funding
Promote resilience over longer term through incentives
for banks to fund activities with more stable sources of
funding
A structural ratio
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Global liquidity standards
Liquidity Coverage Ratio (short-term)
Net Stable Funding Ratio (longer-term, structural)
Net cash outflows over a 30-day time period
Stock of high quality liquid assets≥ 100%
Required amount of stable funding (ie uses)
Available amount of stable funding (ie sources)> 100%
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Introduction of the new liquidity standard
New set of standards requires careful approach
LCR
• Observation period from 2011
• Introduction as a minimum standard in 2015
NSFR
• Observation period from 2012
• Introduction as a minimum standard in 2018
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Allow sufficient time for a smooth transition
The timetable for implementing the new standards is very
generous
This recognises the need for banks to raise capital and
retain earnings in order to meet the new requirements
It also highlights the Basel Committee‟s commitment to
avoid stifling economic recovery
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Transition to the new regime
Basel III: a substantial strengthening of existing
requirements
Transition arrangements to enable banks to meet the new
standards while supporting the economic recovery
Transition arrangements :
• From 2013 to 2018
• Gradual phase-in of some provisions
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2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January
2019
Leverage Ratio Supervisory monitoring Parallel run
1 Jan 2013 – 1 Jan 2017 Disclosure starts 1 Jan 2015
Migration to
Pillar 1
Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%
Minimum common equity plus capital conservation buffer
3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials )
20% 40% 60% 80% 100% 100%
Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus conservation buffer
8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5%
Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital
Phased out over 10 year horizon beginning 2013
Liquidity coverage ratio Observation
period begins
Introduce minimum standard
Net stable funding ratio Observation
period begins
Introduce minimum standard
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Going forward
Timely and consistent implementation of Basel III
• BCBS member countries to translate Basel III rules into
national legislation and regulations by beginning of 2013
• Basel III requirements will take effect from beginning of
2013 and will be progressively phased in until 2018
• Beginning of 2019 – Basel III framework should be in place
During the phase-in process, BCBS to monitor implementation
to detect & correct possible unintended consequences
In general, FSB and BCBS to actively oversee effective
implementation of the regulatory reform
• FSB: Peer National and Thematic Reviews
• BCBS: Standards Implementation Group (SIG) Reviews
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Going forward
BCBS to continue standard setting work
• Fundamental review of the trading book
• Reducing reliance on external ratings in the regulatory
capital framework
• Framework for systemically important banks (together with
FSB)
• Updating cross-border bank resolution recommendations
• Revision of the Core Principles for Effective Banking
Supervision
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Basel III conclusions
Basel III: a comprehensive reform
• Capital requirements (minimum and buffers), leverage,
liquidity…
• Micro and macro-prudential components
Main decisions taken – final text issued in December 2010
Significant strengthening of the regulation
• Banking system should be more resilient in the future
Long transition period to avoid negative impact on the
economy in the short-term
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Questions
Elizabeth Roberts
Director
Financial Stability Institute
Bank for International Settlements